Distress & Turnarounds

Equitable Subordination and Recharacterisation

Two different attacks on the same claim: one says you behaved badly and should be paid last, the other says what you called a loan was never a loan at all. Learn which one applies, and how each is actually proved.

  • Expert
  • 12 min total
  • 13 chapters

What decision this helps you make: Whether an insider loan, a sponsor advance, or an aggressive lender's claim will be paid as debt, pushed behind other creditors, or treated as equity and paid nothing.

What this topic is

Equitable subordination is a statutory remedy allowing a bankruptcy court to move an otherwise valid claim behind other claims because of the claimant's inequitable conduct. Recharacterisation is different in kind: it holds that an advance labelled as a loan was, in economic substance, a capital contribution, so there is no claim to subordinate, only an equity interest that sits behind every creditor. One is about behaviour and is remedial. The other is about substance and is definitional.

Why it matters

Sponsors lend to their portfolio companies. Founders advance money to keep the lights on. Lenders exercise control rights aggressively. Each of those is ordinary conduct that can, in the wrong circumstances, convert a claim worth a hundred cents into a claim worth nothing. If you are structuring an insider advance, buying a claim held by an insider, or evaluating an estate's causes of action, these two doctrines determine what the paper is actually worth.

Who should learn it

Sponsors and family owners funding companies they control, private-credit lenders with board seats and control rights, restructuring professionals evaluating claim objections, distressed investors pricing insider claims, and lawyers structuring shareholder loans.

What you will understand

  • The three-part Mobile Steel test, and how the standard changes for insiders and non-insiders
  • The multi-factor recharacterisation analysis and the circuit split over where the power comes from
  • Why the two doctrines produce very different outcomes on the same facts
  • How to structure and document an insider advance so that it survives both

Prerequisites

Common misconception

"We papered it as a loan with a note, a rate, and a maturity date, so it is debt." Documentation is one factor out of eleven or more, and it is the factor a court trusts least, because the insider chose the label. What actually drives recharacterisation is whether an outside lender would have made the same advance on those terms, whether the money went to fund operating losses or to buy capital assets, whether the maturity was ever enforced, and whether the company was so thinly capitalised that no third party would have lent at all. A perfectly drafted note advanced to a company with no capacity to repay it, by the person who owns the company, is the paradigm case for recharacterisation.